For defined benefit plans that are underfunded or accruing future obligations, private investments may be an important path to higher returns – especially in today’s low-return environment, says Cambridge Associates

Boston, MA (Feb. 3, 2016) – The vast majority of U.S. defined benefit pension plans – as many as 70% – have participants who are still accruing benefits or are open to new employees, according to data from the Pension Guarantee Corporation. Many of these plans will need to generate strong returns for years to come in order to remain appropriately funded and pay out future obligations, and many pensions are challenged with funding gaps already.

But today’s environment of low interest rates and high valuations means that go-to assets, namely public equities and bonds, may not generate the strong returns needed for the long-term horizon for which these plans invest. Consequently, many underfunded and still-accruing pensions are facing serious headwinds.

Plan sponsors, therefore, might benefit from evaluating how private investments can offer a path to higher returns and, ultimately, a greater probability of increasing funding levels and meeting obligations, according to “Private Investments: Filling a Pension’s Return Void,” a new report from Cambridge Associates, a global investment advisor to pensions and other institutions.

“It would be a mistake for many pension funds not to consider private investments,” says Jennifer Urdan, Managing Director at Cambridge Associates and co-author of the report. “A well-constructed private investments program, including key growth drivers such as venture capital, growth equity, buyouts and selected debt-related and real assets strategies, has outperformed public markets over the long term.”

Opportunity for Pensions in Private Investments Remains Untapped

As of December 31, 2014, the Cambridge Associates Global PE/VC Index generated returns of 12.2%, 9.8% and 14.9% in time horizons of 10, 15 and 20 years, respectively. These results, produced over an appropriately long period of time, were significantly higher than those realized by publicly traded equities over the same timeframes. For those periods, the MSCI ACWI, a global public equity benchmark, returned 6.1%, 3.3% and 7.1%. The Global PE/VC Index has surpassed the target many investors have had for private investments – to generate returns that exceeded public equities by 300 bps or more over the long term.

“Private investments have demonstrated outperformance compared with public markets over a long period of time. When skillfully implemented, they may have the potential to improve a plan’s funded status, and therefore should play an integral role in growth strategies for pension funds that can lock up even a limited amount of capital,” says Brian McDonnell, Global Head of Cambridge Associates’ pension practice.

According to industry data, the average private equity allocation among defined benefit pension plans is 5.5%. “If private investments can continue to beat public equities by 300 bps per year, then shifting a total of 15% of assets from public equities to privates could boost the portfolio’s total return by 45 basis points per year,” McDonnell says.

Private Investments Aren’t Easy – But They May Be Worth It

Despite their potential for outperformance, some investors are reluctant to allocate to private investments for a range of reasons, including illiquidity, transparency, complexity and cost. But in many cases, plan sponsors can navigate each of these concerns successfully, the report says.

“Maintaining a long-term mindset and time horizon is necessary. Typical buyout and venture capital funds have 10-to-15 year fund lives and may take six years or more to generate returns,” says Urdan. “Patience and diligence are both virtues, and long-term success depends on the ability to exercise them.”

“Manager selection is especially important when allocating to private investments; there is a dramatic difference between the best performing and worst performing private investments,” she adds. According to the Cambridge Associates Private Equity Index, private equity funds from vintage year 2008 produced internal rates of return (IRR) that ranged from 150% to -15% while vintage year 2002 saw IRR ranging from just over 50% to -100%.”

Unlike public companies, most private companies do not have to file public financial statements, limiting the in-depth information available to outsiders. Savvy investors can address this lack of easy transparency through due diligence, monitoring and maintaining long-term relationships with market participants.

“Private investments have legitimate issues that investors should take seriously and evaluate. These issues are navigable, and the record shows that private investments have added significant value compared to public markets; a private investment allocation may increase a pension fund’s probability of meeting obligations and closing funding gaps,” adds Urdan.

This release is provided for informational purposes only and is not intended to be investment advice. Any references to specific investments are for illustrative purposes only. The information herein does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. This release is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. Past performance is not a guarantee of future returns. With regard to any references to securities indices, such indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index.

The Cambridge Associates Global PE/VC Index is an index based on the financial information contained in CA’s proprietary database of Global private equity and venture capital funds.

The MSCI ACWI captures large and mid-cap representation across 23 Developed Markets (DM) and 23 Emerging Markets (EM) countries.